The ABC Company CFO is considering leasing equipment rather than purchasing new equipment. The equipment budget for 2020 is $55,000,000. The company uses a 10% weighted average cost of capital. The current long-term debt financing interest rate is 5% and the company tax rate is 50%. The equipment is depreciated over 10 years for accounting purposes while the tax rules allow the equipment to be depreciated equally over two years. The present value of the tax depreciation benefit is $23,865,000. A lessor has agreed to provide a lease for the equipment to the company for $5,800,000 per year before taxes for 10 years (assume a tax rate of 50%). There is $5,000,000 of residual value at the end of the lease. The lease debt would be booked as a long-term obligation along with a long-term asset. Required: Prepare an analysis of whether a lease is advantageous compared to a purchase and financing of the $55,000,000 of equipment. What are two (2) potential benefits to consider in the leasing decision and, if the lease debt was the best option, is there a covenant issue to be negotiated? Describe the advantage to the company regarding the difference in the depreciation timing under accounting rules versus tax rules for a $55,000,000 purchase. How does the concept of match term funding apply in the decision process of the CFO? How does it compare to the forecasted financing strategy for 2020?

EBK CONTEMPORARY FINANCIAL MANAGEMENT

14th Edition

ISBN:9781337514835

Author:MOYER

Publisher:MOYER

Chapter3: Evaluation Of Financial Performance

Section: Chapter Questions

Problem 17P

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The ABC Company CFO is considering leasing equipment rather than purchasing new equipment. The equipment budget for 2020 is $55,000,000. The company uses a 10% weighted average cost of capital. The current long-term debt financing interest rate is 5% and the company tax rate is 50%. The equipment is depreciated over 10 years for accounting purposes while the tax rules allow the equipment to be depreciated equally over two years. The present value of the tax depreciation benefit is $23,865,000. A lessor has agreed to provide a lease for the equipment to the company for $5,800,000 per year before taxes for 10 years (assume a tax rate of 50%). There is $5,000,000 of residual value at the end of the lease. The lease debt would be booked as a long-term obligation along with a long-term asset.

Required:

Prepare an analysis of whether a lease is advantageous compared to a purchase and financing of the $55,000,000 of equipment.
What are two (2) potential benefits to consider in the leasing decision and, if the lease debt was the best option, is there a covenant issue to be negotiated?
Describe the advantage to the company regarding the difference in the depreciation timing under accounting rules versus tax rules for a $55,000,000 purchase.
How does the concept of match term funding apply in the decision process of the CFO? How does it compare to the forecasted financing strategy for 2020?

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